The Case Against Floating Currencies

Monetary fragmentation is inconsistent with the globalization of business.

By

Manuel Hinds

Updated Dec. 20, 2010 12:01 a.m. ET

It is ironic that the international monetary system of floating currencies is based on a theory called the "Optimal Currency Area" that celebrates the freedom of central banks to print money at will. The idea is that total freedom to create money would promote global progress and employment, smooth out business cycles, and prevent bubbles and their associated crises.

The irony is that the system is obviously suboptimal. It goes against the grain of globalization, the process that is defining our economic times. To accommodate the central bankers' wishes to control their own currencies, the floating system requires splitting the world's monetary markets into as many currency areas as there are countries.

This introduces a grave fragmentation in the international monetary markets precisely when all other markets, including the financial ones, are coming together into a single global market. It creates obstacles for the operation of the emerging global chains of production as well as for the international allocation of resources. Fragmentation also opens the door for currency and financial crises, turning capital flows, a naturally stabilizing force, into a destabilizing one through currency speculation.

Unbridled monetary printing led us to the collapse of Bretton Woods in the late 1960s and then into the stagflation of the 1970s and early 1980s. Then, after a brief recess that ended in the mid-1990s—the result of Paul Volcker's refusal to print money during his tenure as Federal Reserve chairman—we returned to trigger-happy monetary creation.

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As a result, in the past 15 years we have gone from bubble to bubble, and from bust to bust, printing money first to keep the economy going; then to overcome the bursting of the dot-com bubble, then to sustain a triple bubble of housing, securitized instruments and commodities; then to overcome the effects of the bursting of these bubbles, which is leading to a second commodity bubble and a boom in emerging markets that seem to be waiting to go bust. It is as if we believe that by printing money we can remove hard budget constraints.

Worse, as happened in the mid-1930s, when currencies also floated, countries are engaging in currency wars that nobody can possibly win. The objective of all warriors is to depreciate their currency more than the rest of the world. In the process, while all currencies are debased, the floating system is failing to perform its most elementary promise: absorbing international imbalances. As with the United States and China, the absorption of these balances has ceased to be based on automatic, economic processes and has become the subject of political confrontations.

This failure should lead us back to the drawing board to re-design the international monetary system, reversing the trend that prevailed during the 20th century. We started that century with a fundamental international currency, gold, which kept its value through time and was widely accepted around the world. We ended the century with more than 150 currencies that change their value constantly and at different rates from each other, in such a way that most currencies are not accepted in most countries.

In pursuance of the illusion that money can remove hard budget constraints, we moved from order to disorder. After demonetizing gold in the 1970s, now we are demonetizing money by debasing and politicizing it.

Mentioning the gold standard that prevailed all over the world during the Industrial Revolution brings about derisory comments, some of them suggesting that the value of gold was based on fetishism. This is a mistake. The gold standard was a highly rational system. It kept prices constant through centuries and provided an automatic mechanism to remove international imbalances, such as those that are creating today's currency wars, without the help of any international bureaucracy.

The gold standard achieved this not because of any mystical property of gold itself but because it was an impersonal system. Central banks or governments could not tamper with monetary creation. This is what we need today.

Mr. Hinds is the former finance minister of El Salvador and the co-author of "Money, Markets and Sovereignty," which won the Manhattan Institute's 2010 Hayek Prize. This op-ed is adapted from Mr. Hinds's remarks upon receiving the Hayek Prize.

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